UK: MiFID and CRD Implementation: Organisational systems & controls

FSA has published its proposals on implementation of the systems and controls requirements in both the Market in Financial Instruments Directive (MiFID) and the Capital Requirements Directive (CRD). Its core proposal is that there should be a common platform of systems and controls which will apply to all firms who are subject to one or both of MiFID and CRD. The new requirements are, in many respects, largely in line with current FSA Rules but there are some significant alterations.

Key changes include:

• Need to formalise, re-document and potentially strengthen compliance and risk mitigation controls;

• Some additional HR requirements, particularly concerning the competence of agents’ and outsourcing providers’ staff;

• Need to review and re-document outsourcing arrangements

• Need for full conflicts review across all group companies and new conflicts management procedures.

MiFID and CRD Implementation: Organisational systems & controls

FSA has published its proposals on implementation of the systems and controls requirements in both the Market in Financial Instruments Directive (MiFID) and the Capital Requirements Directive (CRD). These are contained in CP06/9. FSA’s core proposal is that there should be a common platform of systems and controls which will apply to all firms who are subject to one or both of MiFID and CRD.

MiFID and CRD impose similar but not identical requirements in relation to firms’ systems and controls. FSA argues that it is sensible to have one set of rules (the common platform) because most firms are subject to both MiFID and CRD, and that having two similar sets of requirements running in parallel would be undesirable. There is therefore some levelling up – "gold plating" – where requirements under MiFID are higher than under CRD, for example in relation to outsourcing, or vice versa. In some areas, where the distinction is justified, there will be different requirements for MiFID and CRD firms, examples being in relation to business continuity, and certain risks specific to CRD firms. In these circumstances, firms who are subject to MiFID and CRD will have to comply with both the MiFID and the CRD requirements (in practice compliance with the higher obligation will often satisfy both rules).

FSA says that its approach to MiFID implementation is pragmatic and proportionate, fulfilling the Directive in a way that makes sense for the UK market. It will implement MiFID through "copy-out" so as not to place additional obligations on firms, and will only impose additional obligations where they are both consistent with MiFID and justified in their own right. FSA will also review existing Handbook provisions, eliminating obsolete material.

FSA considers that implementing a common platform is consistent with its stance on principles-based regulation. Setting requirements at a high level makes senior management responsible for determining appropriate processes and controls. FSA has been sparing in its use of guidance, in many cases using only recitals from MiFID as guidance to a detailed provision. For example, FSA does not define what is "critical or important" in the context of outsourcing (over and above the limited explanation in the implementing Directive), because a firm’s management should determine this. Well-managed firms can, however, secure a regulatory dividend because FSA will take robust systems and controls into account in determining whether a firm requires system improvements or additional capital.

There are three elements:

• FSA must implement CRD by 1st January 2007, so a CRD firm must observe the requirements of CRD by 1st January 2007.

• FSA must implement MiFID by 1st November 2007, so a MiFID firm must observe the common platform by 1st November 2007.

• To avoid the need to introduce two new sets of procedures, MiFID/CRD firms may adopt all (but not part) of the common platform at any time between 1st January and 1st November 2007.

In very general terms:

• A firm will be caught by MiFID if it carries on investment business in securities, derivatives or units in collective investment schemes.

• A firm will be caught by CRD if it is a bank or building society, or it is caught by MiFID – the key exception is that a firm which only advises on and/or arranges transactions and which does not hold client money will not fall within the scope of CRD (even though it may be within the scope of MiFID).

Most investment firms and banks in the UK will be caught by both MiFID and CRD, hence the decision to adopt a common platform.

On a quick read, the concepts set out in the new rules all look familiar. They are largely in line with current FSA requirements. However, the devil is in the detail. As firms perform gap analyses, it will become apparent that some significant changes will be required to existing procedures.

A firm must have robust governance arrangements with a clear organisational structure, well defined, transparent and consistent lines of responsibility and effective processes to identify and manage risk (SYSC 4.1.1).

The decision-making process and organisational structure must be documented, as must be reporting lines, functions, and allocation of responsibilities. There should also be adequate internal control mechanisms, including in relation to information security (SYSC 4.1.4).

There are specific requirements for business continuity which differ, depending on whether a firm is caught by MiFID or CRD. A MiFID firm must maintain business continuity procedures so that investment services can be maintained if there are interruptions to the firm’s systems and procedures. A CRD firm must maintain business continuity plans to cover severe business disruptions. The principal difference is that MiFID requirements catch investment services only, whereas CRD requirements cover the whole of the firm’s business.

Well run firms will almost certainly fulfil these requirements already, but they must be satisfied that proper documentation is in place to substantiate this.

A firm must have adequate policies and procedures to ensure compliance and to detect the risk of failure to comply with its obligations (SYSC 6.1.1, 6.1.2).

A firm must have procedures to identify risks, set tolerable risk levels and manage risks in accordance with its chosen risk tolerance. Senior management must approve and periodically review these (SYSC 7.1.2 - 7.1.4).

A firm must perform regular monitoring and evaluation of:

• its organisational systems and controls (SYSC 4.1.12);

• the skills, segregation of functions and procedural awareness of staff (SYSC 5.1.14);

• its anti-money laundering systems (SYSC 6.3.3); and

• the adequacy of its risk management policies and procedures (SYSC 7.1.5).

MiFID calls for policies that ensure compliance and detect the risk of failure, which is higher than the current requirement to "take all reasonable steps". As a result, current processes may need to be improved to move closer to the (unattainable) MiFID standard.

A firm’s senior personnel must be of good repute and experience (SYSC 4.2.1).

A firm’s staff and agents (including staff at outsourcing providers) must have the necessary skills, knowledge and expertise to discharge their responsibilities (SYSC 5.1.1) and must be aware of procedures applicable to their roles (SYSC 5.1.12).

There must also be appropriate segregation of functions, in particular to prevent conflicts (SYSC 5.1.6, 5.1.7).

The new requirements go further than existing training and competence rules by including outsourced staff and highlighting procedures and segregation. In particular, firms should ensure that staff working for outsourcing suppliers are appropriately skilled. This can be achieved through a combination of contractual terms and performance monitoring. Second, firms must ensure that training includes formal instruction on applicable procedures, and that training records confirm this. Third, firms must ensure that existing segregation procedures are adequately documented.

New MiFID outsourcing requirements apply to the outsourcing of all "critical or important" functions. FSA has not provided any guidance on the meaning of "critical or important" as it considers this to be an issue for senior management within each firm. There is, however, a limited explanation contained in the MiFID implementing directive. The test is whether a defect or failure of the outsourced function would materially impair compliance with conditions and obligations of authorisation or other obligations under the regulatory system, financial performance or continuity of relevant services and activities. In other words, most functions with any link to investment activities are likely to be considered critical or important. There are, however, some express exemptions, including legal advice, training and the provision of standard services such as price feeds. Intra-group outsourcings and ancillary services, such as foreign exchange, are expressly within scope.

On an outsourcing, the principal requirement will be to take reasonable steps to avoid undue additional operational risk. A firm will remain responsible for compliance, even where it has outsourced a function and there can be no delegation of management responsibility. The basic approach will be similar to the existing regime: due diligence on the outsourcing provider, a proper contract, sensible relationship management and an effective exit strategy. There are, however, 11 specific conditions that must be satisfied. Many of those conditions are similar to FSA’s existing guidance, but two become express requirements for the first time.

• a firm must retain the necessary expertise to supervise the outsourced function; and

• a firm must be able to terminate the outsourcing arrangement without detriment to the continuity and quality of client service. This latter requirement is a high standard. Firms may not be able to bring the function back in-house, so they will need to be aware at all times of what other outsourcing providers can offer and how services can be transferred.

Firms must review and, where necessary, amend existing outsourcing arrangements before 1 November 2007.

A firm must take all reasonable steps to identify conflicts of interest between it, its group and its staff and its customers, and between customers (SYSC 10.1.2), but only where there is customer detriment (SYSC 10.1.3, 10.1.4). The rule applies across all regulated and ancillary activities (not just those within the scope of MiFID or CRD).

A firm must then take all reasonable steps to prevent such conflicts adversely affecting the interests of its clients (SYSC 10.1.6).

A written group-wide policy that identifies conflicts and specifies procedures to manage them is required (SYSC 10.1.7 – 10.1.8). This policy must provide for:

• limiting flows of information (FSA provides that a firm may continue to rely on a Chinese wall (SYSC 10.2));

• separate supervision of employees;

• limiting staff having parallel involvement in conflicting activities;

• limiting improper management influence over conflicting activities;

• de-linking remuneration from conflicting activities;

• such other steps that a firm needs to take to avoid conflicts.

One of the key changes under MiFID is that disclosure of a conflict to a customer can no longer be the principal method of conflict management. Only if all the other procedural steps adopted by a firm are insufficient should a firm rely on a customer’s consent to disclosure of a conflict (SYSC 10.1.10). This is a significant change. FSA states that in many cases it would expect to see a firm not only using a structural approach to handling a conflict, but also disclosing the existence of the conflict to the customer. Disclosure is likely to be desirable in any event because, although it may not satisfy FSA rules, disclosure and informed consent is an effective means of conflict management under English law. As a result, it remains an effective method of reducing risk.

There are three key impacts:

• Conflicts must be viewed group-wide and can no longer be managed by placing conflicting functions in separate companies.

• Firms must adopt structural protections to manage conflicts – effectively, a formal policy of independence – and only rely on disclosure and consent as a last resort.

• Firms must prepare a formal conflicts policy, extending to all customers (including eligible (i.e. market) counterparties).

Consistent with these impacts, firms should perform a conflicts review of affected businesses to identify conflicts, assess the adequacy of existing conflicts mitigations in light of the new requirements and introduce new procedures when appropriate. Finally, firms should reflect these steps in a written conflicts policy.

Most banks and investment firms will be subject to the common platform. They must therefore decide whether they wish to move to CRD compliant systems on 1 January 2007 and then to MiFID compliant systems by 1 November 2007, or whether to move to the full common platform on 1 January 2007. Clearly, the latter option will involve only one change of procedures, which may seem preferable. However, it will require firms to have completed a full systems and controls review, including on labour intensive non-CRD areas such as outsourcing and conflicts, by 1 January 2007.

Firms may also wish to lobby FSA on its proposals. Responses to the current consultation paper should be submitted by 19 August 2006.

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq

The original publication date for this article was 31/05/2006.